When investing it’s important on focus on what you know, what’s knowable, and what’s not knowable or predictable – like the future.
I would put interest rates in the category of difficult to know or predict.
It’s a fact that interest rates are currently low versus history, and in many places at record lows. It’s also expected they will remain low, particularly given the current state of the global economy and the unprecedented levels of central bank indebtedness.
Low interest rates are good for borrowers, but bad for savers
Savers forgo income they would ordinarily earn if interest rates were higher. As a result, investors tend to search for alternative investments that offer the prospect of higher returns.
In a low rate environment, money tends to flow from low yielding assets like bank deposits and government bonds into assets that can provide a higher yield, the potential for capital gains, or both. Examples of such assets include corporate debt, structured credit, real estate and equities.
As demand in these asset classes rise, so too tends to their price. At the same time the return investors require to hold these assets tends to fall as they lower their return expectations relative to those provided by lower risk assets. This has the effect of increasing the value of these assets.
Mitigating risk in the hunt for enhanced returns
The search for enhanced returns in a low rate environment can be a fruitful exercise, but it’s not without danger. Higher returns are often accompanied with higher risk, and many an investor has been burnt chasing attractive returns in products with significant risk.
To mitigate this risk, investors should seek managers with a track record of success over different market cycles, ensure they understand how they are achieving the enhanced returns, along with the potential for loss in doing so. Ensuring the investment manager has the appropriate alignment with the investor can go a long way to protecting themselves from risk.
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